When an Earn-Out Turns a Business Sale Into a Tax Dispute

The situation

Hua spent close to two decades building a group of quick-service restaurant locations around Peterborough, growing from a single franchise to several units before deciding it was time to retire. In 2024, he agreed to sell the entire operation to Yanni, an experienced multi-unit franchise owner from outside the region who was looking to expand his own portfolio. The deal closed at a total price of roughly $8,000,000. Of that, about $2,400,000 was structured as an earn-out — additional payments spread over the following three years, tied to how well the locations performed after the sale.

Earn-outs are common in business sales. They let a buyer defer part of the price until the business proves itself, and they let a seller capture upside if performance holds. Hua's original lawyer for the sale, a general practice firm he had used for years, drafted the purchase agreement and closed the deal. Tax treatment of the earn-out was not a focus of that work. Hua and Xia used the proceeds to retire comfortably, assuming the earn-out payments would be taxed the same way as the rest of the sale — as a capital gain, where only half the amount is included in taxable income. Neither of them gave the earn-out much thought once the deal closed. The first payment arrived on schedule the following year, they reported it on their return the way their accountant had always reported the practice's income, and the file went quiet for a long stretch. It did not occur to either of them that the same three-year window meant to give Yanni time to prove the business out was also a window during which the CRA could still take a close look at how the payments had been characterized in the first place.

The tax problem

Nearly two years after closing, the Canada Revenue Agency reassessed Hua's tax returns for the years the earn-out payments were received. The CRA's position was that a meaningful portion of those payments should be treated as fully taxable business income rather than as part of the capital gain on the sale.

The CRA has a long-standing administrative approach that allows earn-out payments in a business sale to be treated as an addition to the sale price — and taxed as a capital gain — but only where specific conditions are met at the time the deal is struck. Broadly, the payments have to be genuinely tied to the value of the business itself, the amount of the eventual payout has to be something that could not reasonably be pinned down when the deal closed, and the arrangement generally has to run for a limited number of years. Where an earn-out instead functions as a disguised salary, bonus, or consulting fee for the seller's continued involvement, the CRA treats it as ordinary income, taxed in full.

Hua's earn-out agreement blurred that line. Part of the formula was tied to store revenue, which supported a capital gains argument. But another part of the payment schedule was contingent on Hua remaining available for consultation and a smooth handover during the transition, with payments continuing only if he provided that support. The agreement never separated the two, and nothing in the deal documents addressed how the CRA's conditions applied. Under a straight capital gains characterization, Hua would have included half of the $2,400,000 in income, taxed at roughly $640,000. Treated in full as ordinary income, the same amount would generate a tax bill closer to $1,280,000 — a difference of roughly $640,000 that the CRA was now pursuing.

What we did

1. Filed a notice of objection within the strict deadline. A reassessment can only be formally disputed within a limited window after it is issued. Missing that deadline forecloses the right to object at all, so this came first, before anything else.
2. Reconstructed the earn-out's real structure. We went back through the purchase agreement, the schedules attached to it, and Hua's correspondence with the buyer's side during negotiations to separate what the earn-out was actually compensating. Some of it clearly tracked the ongoing performance of the locations themselves — the kind of contingent pricing the CRA's own policy is meant to accommodate.
3. Argued for a split characterization. Rather than defending the entire $2,400,000 as capital gain, we took the more defensible position that the portion tied to store revenue met the conditions for capital gains treatment, while the portion tied to Hua's continued availability did not. Conceding the weaker part of the claim gave the stronger part more credibility with the CRA appeals officer reviewing the file.
4. Negotiated directly with the CRA's appeals division. Objections are reviewed by an appeals officer independent of the auditor who issued the reassessment. We presented the split analysis with the supporting documentation, rather than letting the file default to the auditor's original all-or-nothing position.
5. Advised on the realistic alternative. Hua could have pushed the dispute to the Tax Court of Canada rather than settling with the appeals officer. We laid out honestly what that would cost in time and legal fees, and what the odds looked like given how the earn-out had actually been drafted, so he could weigh a negotiated result against a court fight with no guaranteed outcome.

The outcome

The CRA appeals officer accepted the split characterization. Roughly $1,300,000 of the $2,400,000 earn-out was allowed capital gains treatment, consistent with the revenue-based portion of the formula. The remaining roughly $1,100,000, tied to Hua's post-sale availability, was confirmed as ordinary income. The net result was additional tax owing of about $290,000 above what Hua had originally reported — well below the roughly $640,000 the CRA had first sought, but a real and unavoidable cost.

That outcome reflected the deal as it was actually written, not as Hua and his advisors at the time had assumed it would be treated. Had the earn-out been drafted with the CRA's conditions in mind before the sale closed — separating the performance-linked payments from any consulting or retention component, and avoiding language that tied payment to Hua's continued personal involvement — a much larger share of the $2,400,000 could plausibly have qualified for capital gains treatment from the outset. The dispute, the professional fees to resolve it, and the $290,000 in extra tax were all avoidable costs of a sale agreement that was never built with its tax consequences in mind.

Hua and Xia paid the reassessed amount from the sale proceeds still held in savings. It was not the retirement they had planned around, but it was a contained and known cost rather than an open-ended dispute heading toward court. Xia, who had handled the household's bookkeeping through the years Hua ran the restaurants, said afterward that the hardest part was not the dollar figure but realizing how much of it had turned on a single paragraph of a contract neither of them had thought to question at the time. They still recommend Yanni to other operators looking to sell, and the two families remain on good terms — the dispute, in the end, was with the CRA, not with each other.

What you can learn from this